The current array of contradictory economic data – particularly in the U.S. – combined with factors such as political and trade war rhetoric are making it difficult to decipher what is really happening in the markets and broader economy. John Pattullo, Co-Head of Strategic Fixed Income, provides insight on the inflationary impulse running through the markets and the chances of a soft or hard landing for the U.S. economy.
- In October 2018, when the markets were full of euphoria about growth and expecting bond yields to rise, we held the opposite view. Now, however – after bonds rallied in the interim – we believe that the trough in economic activity is with us.
- Currently, bond and equity markets are sending contradictory signals: In the U.S., bond markets see the economy as late cycle, signaling a hard landing, while equity markets see it as midcycle with a soft landing ahead.
- While we agree that bond markets ran a bit ahead of themselves and now reversed course somewhat, we are not convinced that a breakout of sustainable higher growth and higher inflation is on its way.
John Pattullo: It was actually last October, Treasury yields were up at 3.15%, real yields were at 1%, the dollar was high, oil price was high, interest rates were going up and there seemed to be a lot of kind of stress factors. Frankly, in hindsight, the Fed were over tightening monetary policy. We felt there was going to be a crack and a break, because real rates had come up so much, and that is exactly what happened. But remember, back then, it was kind of peak euphoria. People thought growth and inflation were going to break out, Treasury bond yields were going to break the magic 3.25.
And now we are kind of at the other side of the boat, if you like; we are at the trough. We are arguably at the trough of economic activity. The Fed has done a fantastic pivot; the Fed has cut rates three times, and, if you like, the bond market may have got too pessimistic. And now I think you are getting a bit of reflationary impulse away from the pessimistic bond view and the slightly more optimistic equity view.
I think what is particularly pertinent is that there is a, as often, there is a contradiction between equities and bond markets. So the equity market, which obviously the S&P [500® Index] hit recent highs and has hit new highs most days, is really saying there is going to be a soft landing and we are mid-cycle. Whereas the bond market, which is always more miserable, saying, “Well no, there is a hard landing coming, and it is late cycle.” And there are lots of charts and slides and debate I could show you to back up both schools of thought if you like.
So, if you like, the jury is out between the equity guys looking for the mid-cycle soft landing and the Fed hoping for it. It did happen in ’94 and ’95, so history would suggest there’s a one-in-four chance of it happening. We think it’s probably higher. It’s not inconceivable you might get some sort of soft landing and then a hard landing. But I think what is true, and if you like the tell, is you certainly won’t get a soft landing with a strong dollar. So unless the dollar weakens quite materially from here, we think it is very hard to get a soft landing.
On the hard landing side, I think there’s a number of things to watch, not just stock levels and inventory levels and new orders and all that sort of traditional things, but also unemployment really is the tell; is unemployment going to tick up and is it going to spread from the manufacturing sectors into the service sectors and kind of cause a vicious spiral, which is quite hard to reverse.
So I think we are sort of sympathetic that the bond market ran ahead of itself and now it has backed up a little bit. But on the scheme of things, that is not that material. We are not seeing a massive breakout in some of the cyclicals and the value indexes like transports and financials and banking and so on. But they have moved a little bit. So I think it is an environment where you probably want a bit less duration, because it has run pretty far.
Sometimes it is not that obvious and there are endless things that we are all looking at between this soft landing, hard landing, late-cycle, mid-cycle scenario I have described, lots of data going on, trade wars and various other things as well. But I am just saying we are kind of the other side of the boat from where we were really last October and that in itself is pretty interesting.